Now that we are well into the final quarter of the fiscal year, many entrepreneurs are trying to make sense of the results of their businesses for 2018. At the same time, soon-to-be entrepreneurs are putting together their business plans in an effort to get a handle on how financially feasible their grand idea could be. In either scenario, the three primary financial statements that a business owner or investor will be most interested in are: The Income Statement (Profit and Loss), the Balance sheet and the Cash Flow statements.
The income statement provides information for understanding how much the business must spend on every dollar of sale before deducting other variable expenses. So, for every operating period the income statement will tell you how much revenue was made and how much expenses the company incurred to earn the income for that period. It is a key tool for measuring the performance of your business over time.
Besides the knowledge that Revenue – Expenses = Income, the figures in the income statement are also used to answer questions such as:
- How much sales do we need to make in order to break even?
- How many units must we sell to break even?
- How much money does our sales mix contribute towards our fixed cost? By sales mix we refer to the combination of products and services sold by the business.
- What is our fixed cost per unit? That is the per unit cost from which we cannot get away no matter how many units we produce.
- What is our variable cost per unit?
That is the cost that changes with each unit that we produce and the cost that we can control.
We mentioned break even above, but what does it really mean? It is point or dollar value at which income and cost are equal. At the break even point, you are neither losing money or making a profit.
Now that we know what information we most need to focus on from our income statement, we can turn our attention to the Cash Flow Statement. Most entrepreneurs understand well what director Danny Boyle means when he said, “There’s lot of things that can be solved with cash”.
The cash flow statement is made up of three sections, they are ― 1) the cash flow from operating activities; 2) the cash flow from investing activities; and 3) the cash flow from financing activities.
We all know that cash is the life blood of a business; if a business makes less net income than it spends on operating activities for three consecutive quarters it could mean the business is not financially viable. Signs of financial health problems faced by the business may include its inability to pay bills or loans; its inability to increase dividends to share owners; to pay the owner, or to acquire needed tools and investments for supporting its growth. If your business has a pattern of generating a certain level of cash flow periodically, it will be seen to be stronger and have a greater capacity to take on and service debt, than a similar entity that has unpredictable cash flows.
But, let’s break the cash flow statement into its three bite size sections to find out what we can learn about our business from it.
The cash flow from operations (CFO) tells the owner and investors how much money the business made from its operations. That is ―the cash generated from sales after paying the cost incurred for making the sales (this includes interest on debt, rent, taxes, salaries, inventory, entertainment etc.).
With routine operations out of the way, lets focus on the cash flow from investment (CFI) section, which tells how much is spent on capital expenditure or fixed assets (equipment and tools for the business); cash inflows from joint ventures and acquisitions; and investment in financial assets. Information from the CFI is used in valuing the shares of a business; it also tells if the business is in a growth phase. The higher the investment in fixed assets, the greater the investment in future production and growth; thus, making it easier for potential investors and owners to be confident in the belief that the business is in a growth phase. Which means they are also more likely to invest more in the business.
The third section we’ll look at is the CFF or cash flow from financing. This section shows the commitment of the owners in terms of capital invested (that is monies invested by both the proprietor and shareholders to purchase stock), as well as monies received from employees who purchase stock (Also known as an exercise of stock options). It also provides information on cash inflow from the issuing of debt― such as bonds or debentures. Outward cash flows presented in the CFF include monies used to pay dividends to shareholders. Having explored the three sections of the cash flow statement the key point to remember is―At the end of the day the value of a business is determined by its ability to generate financial cash flow.
The balance sheet is another key financial statement; it provides an overview of the assets owned by a business and its liabilities (what it owes) for a specific period of time. It also tells how much was invested by shareholders, who invested or the kind of shareholders; and is used to calculate the internal rate of return (IRR). The IRR tells how profitable the investments undertaken by the business were.
Another key indicator is the return on assets (ROA). To calculate the value of the ROA, the figure for total assets found on the balance sheet is divided into the net income from the profit and loss statement (income statement). The ROA tells how much and how efficient the business is in generating profit from its assets. If the ROA is to provide meaningful information, the ROA for different quarters or years are usually reviewed to gain an understanding of the direction of profitability and efficiency that was calculated.
In addition, to fixed assets and liabilities, the balance sheet also provides information on intangible assets such as goodwill and intellectual property. Like a selfie, the balance sheet is a picture of financials of your business at a specific point in time. Positioning your business for growth requires comparing balance sheets for different periods, analyzing the changes, and using the information gained to make decisions for driving desired change.
Growing and managing a business means you must understand some of the financials. Let the accountant do the job you pay them for but bear in mind the figures and statements discussed above and asked your accountant about each of them the next time you sit to discuss the performance of your business. Over time you will become a pro in understanding these statements and guiding your business accordingly.
About the author: Meegan Scott, B.Sc. Hons, MBA, ATM-B, CL, PMP., is Jamaica-born Strategic Management Consultant, at Magate Wildhorse Ltd in Toronto. This is a syndicated column and article.